401(k) hardship withdrawals are a costly fix

As we approach the fourth anniversary of the beginning of the generalized American economic meltdown, I'll bet that you still know a few folks who have not managed to extricate themselves from that mess.

In my own personal circle, a few of my friends who've been work-challenged for an awfully long time have taken what might be the worst of all possible self-rescue routes and borrowed from or entirely cashed in their 401(k)s as a survival tactic.

The industry, rather delicately, calls them "hardship withdrawals," and while they might provide some short-term ability to pay the bills and replicate a stream of income, you know in your heart that draining your retirement fund to survive is a really, really bad idea.

A recent piece from Milliman's James Thompson helps illustrate the severity of the strategic damage a hardship withdrawal can cause, though the money might be a welcomed, last resort in times of layoff, mortgage crash or health issue.

The IRS requirements on hardship indicate that the money must be requred for an immediate and heavy financial need - think of your unemployed or unexpectedly ill friend and that might be a no-brainer - as well as adding that the money distributed has to be restricted to the necessary funds needed to satisfy the financial need.

If you've been laid off and the money's simply sitting there in a forlorn 401(k) account, draining the entire fund is an easier and much more dangerous option. The somewhat more controlled hardship withdrawals are a well-regulated but still plausible option in 401(k)s, 403(b)s, 457(b)s and some IRAs.

Here's the worst part, as Thompson outlines in the case of a 30-year-old employee who needs about $15,500 to cover tuition expenses, and opts to pull the money from his 401(k).

In addition to a $100 withdrawal fee, the up-front tax implications are serious: 25 percent federal tax, and a 10 percent penalty for withdrawing under the age of 59 1/2. The employee only gets $10,000 cash, and loses about a third of the money's value. He also loses six months' worth of deferrals and employer contributions.

The long-term implications? That $10,000 emergency gift-to-self, with more than $18,000 of 401(k) investment power, would have ballooned to almost $200,000 if he'd left the money alone until he was 65.

Even worse is the fallout for an unemployed friend who drained not just one but two 401(k) pots from previous jobs; that money is gone, and any hope she had of a self-financed retirement plan has been reset to zero.

The message? Like a payday loan (though that field has been brought under some serious scrutiny, you may have noticed, with the exception of the new late-night TV ads from predatory lenders on Indian reservations), it's the worst route possible to satisfy a pressing financial need.

If the issue comes up as an inquiry, your best advice is the truth - do anything else possible to cover a financial gap, but don't cash in the farm to do so.